Fed signaled larger rate hikes, faster balance sheet reduction. The minutes of the Fed’s March meeting revealed that policymakers are willing to hike rates toward neutral “expeditiously,” saying hikes in 50-basis-point increments could be appropriate, amidst the highest inflation readings in four decades. The minutes indicated that once a neutral policy posture is achieved (which most believe is a Fed Funds rate of 2.5%; it’s 0.5% now), a move toward a tighter policy stance may be needed. They also revealed that, if not for the market turmoil that surrounded Russia’s invasion of Ukraine in the early weeks of the year, many Fed voting members would have preferred a 0.50% hike last month over the 0.25% boost the committee approved.

Regarding the other tool the Fed has at its disposal to slow things down, the Fed’s discussions on reducing the size of its massive balance sheet revealed that the an accelerated reduction could start as early as next month, and that after a three-month phase-in period, the balance sheet could be reduced by up to $95 billion per month; $60 billion in Treasuries and $35 billion in mortgage-backed securities (MBS), roughly doubling the pace of the balance sheet reduction seen between 2017 and 2019.

If you’re a bit befuddled about how the Fed’s actions toward reducing its balance sheet impacts interest rates, here’s how it works: The Fed’s selling of Treasury bonds off its balance sheet suppresses the prices of Treasury bonds and increases Treasury yields (prices down, yields up). Markets parsed every letter of the Fed minutes to get a sense of what pace the Fed will employ when selling its Treasury bond holdings, and how that pace will impact the trajectory of Treasury yields.

The minutes also implied that the Fed may explore selling MBS on the open market once “quantitative tightening” is well underway. The 2-year 10-year Treasury yield curve steepened substantially after the release of the minutes, after going negative by 7 basis points earlier in the week and is now trading at roughly +20 basis points.

Our take: The minutes make it clear that the Fed prefers rate hikes to be frontloaded, and lays bare the Fed’s fear that inflation expectations – the rate at which consumers, businesses, investors expect prices to rise in the future and the degree to which those expectations impact spending and investment decisions today – will become unmoored, which the Fed now sees as a serious risk. As such, they now feel the need to act quickly, but not too quick, to avoid cratering economic growth in the process.

While $95 billion per month in balance sheet reduction sounds like a lot, don’t get too excited, the Fed’s asset holdings will still be above pre-pandemic levels at the end of 2024, both in dollar terms and measured as a fraction of GDP. The last time the Fed announced a sizable balance sheet runoff – at its September 2017 meeting – the unemployment rate had averaged 4.4 percent over the previous three months and core inflation was 1.4%. The overall balance sheet was $4.5 trillion (23 percent of GDP). This time around, the unemployment rate is 3.8%, core inflation is 5.4%, and the balance sheet is $9.0 trillion (37 percent of GDP). Given that the economy is at full employment and core inflation is roughly four times what it was in 2017, it seems the Fed has a green light to be more aggressive in its balance sheet reduction efforts.

Wrapping things up, there was no mention in the minutes about flattening yield-curves – which is sometimes seen as a predictor of looming recession – suggesting that their recent inversion will play a minor part in the Fed’s decisions, with red-hot inflation outweighing any growth concerns. The spread between the yield on the current three-month Treasury bill and wagers on where it will be in 18 months, obtained from the futures market, is the signal Fed policymakers view more suggestive of an imminent recession (keep reading for more on this). While this forward spread has typically moved in lockstep with the yield curve, it is now going in the opposite direction, countering recession calls.